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The new era means new Bank of England governor Mark Carney will be very closely watched indeed

The new Bank of England governor Mark Carney has probably just about settled into his office in his first week at the helm of the Bank of England. He's taking over at a time when there is a big change in the Bank's remit to control credit as well as consumer prices.

It's the end of targeting just inflation for central banks. But, how will it work if they also target financial stability?

As the Bank of England has set up a new Financial Policy Committee (FPC) to manage financial stability alongside its existing Monetary Policy Committee (MPC), it is in some ways further ahead than other central banks in adopting what is termed "macroprudential policy" alongside "inflation targeting."

It's termed macroprudential policy or macroprudential regulation because the central bank is to ensure that commercial banks operate in a prudential manner and regulate systemic or macro risks.

The end of an era

Inflation-targeting began when New Zealand adopted it in 1991, and since then it has become the dominant regime among major economies.

For instance, the Federal Reserve recently adopted a 2% target for inflation and the Bank of Japan has a 1% target.

The Bank of England was granted independence in 1997, charged with targetting inflation and has a 2% target.

The divergence between consumer prices and the amount of cash lent out in the economy meant that central banks hit their targets but missed the problem of growing debt

But, the Great Moderation and the ensuing Great Recession showed the inadequacy of that regime.

The Great Moderation of the past decade and a half referred to business cycles that were more moderate than before. Recall the former British Prime Minister Gordon Brown boasting that he had defeated "boom and bust".

Of course, the bust that followed was spectacular - and not in a good way.

Essentially, inflation was fairly low. In the UK, it averaged 2% and hit the Bank of England's target during the first part of the last decade.

In fact, inflation was low everywhere. Global inflation averaged 17-18% in the 1980s and 1990s, even reaching 35% in 1993. Yet, in the 2000s, inflation was just 4% around the world.

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Inflation worldwide slowed during the 2000s

One of the reasons for low inflation was because China and other emerging economies ramped up their growth and production. Their cheap labour lowered the price of manufactured goods. The so-called "China price" referred to the deflationary impact of China.

Looking ahead, of course, this may no longer be the case as China's costs rise as the country becomes richer.

During the Great Moderation, central banks largely hit their inflation targets, but credit grew rapidly.

The divergence between consumer prices and the amount of cash lent out in the economy meant that central banks hit their targets but missed the problem of growing debt that fed an unsustainable housing bubble in the US.

For instance, credit expanded in the US in the five years to 2007 by a whopping 40.8 percentage points of GDP. And the subsequent bust led to what has been called the Great Recession, as countries such as the US, UK and others experienced the worst downturn since the Great Depression of the 1930s.

Defining financial stability

This is why overseeing the amount of liquidity or cash in the economy is so important, rather than just focusing on consumer price rises.

Now, here comes the hard part.

First, how to define financial stability. The hope is that the next banking crisis can be prevented. But, no one really thinks that it is possible, as financial crises seem to be endemic. It's perhaps more realistic to try to restrict the scale of the next crisis so that it doesn't drag down the whole banking system and the economy with it.

Second, if there are now two targets (price and financial stability), then there must be at least two instruments to meet those aims. So, if the interest rate is used to target inflation, then other tools are needed to target financial stability.

This is where tools such as imposing counter-cyclical capital requirements and sectoral capital buffers come in.

What the former means is that banks would have to hold more capital during the good times, so they lend more prudently during booms. During busts, when their tendency will be to pull back, such requirements may have the opposite effect.

Sectoral capital buffers could mean that certain parts of the market, like mortgages, are subject to specific limits. These are not the only possibilities, as there are are also other tools such as leverage and liquidity ratios.

Making it work

Assuming that the goal is appropriately defined and the tools properly specified, there are still coordination and implementation issues.

For instance, the UK has been in a peculiar position. Inflation has been above the Bank's 2% target for a long time while credit has dried up. This is in a sense the opposite problem from the Great Moderation when inflation was on target while credit grew.

It may mean, though, that the MPC will be wary of injecting more cash at the same time that the FPC would be keen for banks to lend more to support the recovery.

How the Bank coordinates these opposing tendencies will be telling.

Of course, the most important question is whether any of these measures can ensure financial stability.

Ultimately, we all hope that the Bank of England and other central banks can manage to come up with the right set of tools - if not to prevent, then at least to limit the fallout from the next banking crisis so that it doesn't drag the world economy down with it to the same extent as in the 2008 global crisis.

The Bank of England looks to be at the forefront. Even more attention will be paid to the UK's so-called financial "rock star", the new Governor, to see what he can deliver.

Getting this right could mean preventing another banking crisis, so the stakes couldn't be higher.